China and the World of Business • China Business and the World

As China’s film industry struggles to turn itself into a real industry (rather than a government-sponsored propaganda tool-cum-art form,) producers and filmmakers are searching for near- and long-term sources of finance and distribution. Seeking new models with which to finance China’s growing film biz, the gaze of mainland producers naturally turns to markets outside the mainland.

A Bunch of Cash Holes

What they find is that the entire global industry is engaged in the quest for new sources of cash. Even people like Steven Spielberg and Ron Howard, bankable filmmakers both, are finding that it is harder than ever to get the money they need to make their films. Spielberg has not only had to cut a long-term distribution deal with Steve Jobs’ crew over at Disney, he has had to go to India’s Reliance BIG Entertainment for cash as well.

Spielberg’s hunt for production money is a symptom of a wider contagion that has affected the film business. Production costs continue to rise, digital revenue is not ramping up as quickly as is we had all hoped, and younger audiences are spending more time online or playing games. More immediately, the financial crisis has meant that the usual sources of cash have either slowed or evaporated.

All is not gloom, though. For several years now, a new crop of film finance companies pairing hedge funds and private equity directly with producers has not only given Hollywood a much-needed new conduit of cash, it has in some cases brought a more bottom-line approach to production. (Full disclosure: my brother-in-law is an executive at one of these companies.)

A New Kind of Mogul…

At first glance, one of the most intriguing examples of the type is Relativity Media, profiled in this month’s Esquire magazine. The article sounds a hopeful note, positioning Relativity and its 34 year-old leader, ex-venture capitalist Ryan Kavanaugh, as honest water merchants in an increasingly dry land.

Relativity appears to do some smart things. They focus on getting movies made, not optioning a hundred properties and turning one into a film. They ensure costs remain in line with good business sense. They try to earn profit by being sensible about costs and distribution, not trying to make blockbusters.

…Or Just Another Old Quant?

I was really prepared to put Kavanaugh into my pantheon of people who are building the future of Hollywood. But when I got down about two-thirds of the way through the article, things started to go a bit awry. I think this was the paragraph that set off the alarm bells:

“Before Relativity commits to financing a particular movie — either through its slate deals with Sony and Universal or on its own — it’s fed into an elaborate Monte Carlo simulation, a risk-assessment algorithm normally used to evaluate financial instruments based on the past performance of similar products.”

Now, I am nobody’s idea of a “quant,” but neither am I the anti-quant. I like playing with spreadsheets and plugging in assumptions and variables a lot more than I like to admit in polite company. I also think there is a dearth of analytical, quantitative thinking in creativity-driven businesses.

So I like the fact that Kavanaugh and Relativity are trying to bring the sensibilities of management accounting to Hollywood. The future of film is not the subordination of art to business, but the quest for an equitable balance. Kavanaugh’s bottom-line focus while rising above gratuitous bean-counting is a step forward in this regard.

Yet while Relativity would protest that only a part of their decision-making is driven by their computer models, I see cause for concern. Basing investment decisions using computer modeling based on past performance or market behavior is a riskier proposition than the quants might have you believe. Long-Term Capital Management leaps to mind, as do a half-dozen major financial organizations that have similarly vanished into clouds of hubris in the past year.

The Black Swan Cometh

In the entertainment industry, where tastes and media consumption are in the throes of massive change, common sense demands we be especially selective about using the past as a guide. What is the half-life of a set of audience assumptions in a single market like the US, then multiply that across the worlds markets, from whence comes 2/3 of the average film’s revenue.

If, on the other hand, the company’s investment decisions are driven by the knowledge and instincts of its executives, it is likely making decisions on a basis little better than anyone else in Burbank, Santa Monica, or points between.

Relativity may have convinced themselves that the modest goals of their approach (“don’t lose your shirt”) are enough to stave off an unforeseeable catastrophe – a major box-office flop, or even several in a row. If so, I think they are kidding themselves. The recent history of the finance industry has proven that betting your money on the mathematical rationalization of the irrational behavior of millions of decision makers is pure folly.

All of which is why I hope that, despite Relativity’s apparent success to date, we in China decide to eschew such an approach to film finance, at least for the time being. There are far too many more fundamental steps that the industry here could be taking to improve its bottom line and its box office performance.

CORRECTION

Seeking Alpha reader and film executive Andy Almay noted that I my characterization of Spielberg going to Relativity was in error:

“Spielberg didn’t go to Reliance. It was the other way around. Reliance wanted to buy into Hollywood. They also made deals with a number of name performers and down the line they may rue the day. Performers have been notoriously bad at picking successful projects.”

The point, though, remains. When the man who is arguably Hollywood’s most successful and esteemed producer needs to turn some of his creativity to fundraising, all producers will need to do more of the same.